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Profit From This Energy Paradox

The place to be for the long term is oil and gas stocks.

I'm about to contradict everything you've ever heard about energy efficiency. In short, energy efficiency doesn't work, at least not the way you've been led to believe.

While efficient products may reduce energy consumption on a per-use basis, they actually allow us as a group to use even more energy than we otherwise would have. It's called Jevons paradox. I'll explain the relevance of this paradox and which companies are poised to profit from its implications. Plus I'll give you access to three stock picks from our top analysts.

What is Jevons paradox?Jevons paradox explains a fallacy of composition, also known colloquially as the folly of crowds. In other words, it's wrong to conclude that the collection of individuals' actions achieves the same result for the group as a whole. Think of sports fans in a stadium standing up one by one to get a better view. Soon, everyone is forced to stand up just to get the view they had when sitting down. I'll give you an example from the energy and automotive worlds to illustrate Jevons paradox more concretely.

While drivers now bemoan the arrival of $4 gasoline, gas prices in real terms (i.e., inflation adjusted) are only on par with the all-time highs achieved in the 1970s oil shocks and World War I. With the exception of the 1970s, gasoline prices from the Great War until 2000 continued on a steady downward path in real prices. The upshot? A perpetual expansion of the number of miles logged by the nation's drivers, until about 2005.

You can see low gas prices ultimately result in the massive expansion of the suburbs, especially from the 1950s on. Ever-cheaper gasoline simply lowered the per-mile cost of moving to the suburbs, allowing cities to build out instead of up and suburbanites to commute. And with cheap gas, a car culture emerged. The key point here is that lower gas prices led to more consumption.

Efficiency-promoting technology accomplishes exactly the same feat, reducing prices and allowing you to increase consumption, as we see with consumers' consistent decision to increase miles driven over the last six decades. In effect, lower prices led to more aggregate energy use, a result predicted by economist William Stanley Jevons in 1865. In Jevons paradox, he points out that demand for a resource (coal, in his case) increases because efficiency improvements lower the resource's relative cost. Moreover, higher efficiency means higher economic growth, leading to still higher resource use.

In short, energy efficiency by itself can't be a way to reduce energy consumption unless accompanied by group conservation (i.e., limiting aggregate consumption to a given level). If the U.S. ever intends to wean itself off oil and have energy independence, the last thing it needs is lower oil prices. In fact, the higher the price, the better for kicking the oil habit -- whether foreign or domestic. High oil prices make other renewable energy sources competitive and perhaps even make oil ultimately obsolete.

With scarcely a politician claiming that we should actually limit the oil we consume, we should expect the proliferation of more efficiency technology, leading to individual energy savings but higher energy consumption overall. And that supports oil prices, especially as the global economy increasingly backs up against supply constraints.

So where do I invest?With that said, I want to find companies whose competitive advantage strengthens as resources become more constrained. So I think the best strategy is to dedicate a portion of your portfolio to energy, consisting of makers of energy-efficiency products and energy producers.

I'm less inclined to buy automotive companies such as Ford(NYSE: F) and General Motors, not because they don't have growth opportunities (have you heard of China?), but rather because they face the dangerous long-term headwind of rising energy prices. Ultimately, this probably forces them into producing a more European-style car -- smaller and more efficient. But that's not where the high margins are. And with the industry's need to recoup massive R&D costs by cross-licensing technology, rivals are able to access key advances, helping to eliminate or mitigate any one company's dominance. If energy prices grow too high, consumers can also begin to reurbanize, moving back to cities, as we've seen recently.

I think safer longer-term plays are oil majors such as ExxonMobil(NYSE: XOM) and Chevron(NYSE: CVX), which can leverage their scale and finances into new energy areas. As energy prices move up because of increasing supply constraints, these companies can make outsize profits and therefore are able to invest in the next wave of alternative energies. ExxonMobil has already made a move in that direction with its 2009 purchase of gas-rich XTO Energy, while natural gas prices are low. You also see it in the recent move by France's Total(NYSE: TOT) to snap up a majority share of SunPower(Nasdaq: SPWRA), a player in the solar space.

The low-cost producer in a commodity industry is usually the safest bet, especially when prices are at historical lows. That's the case with Ultra Petroleum(NYSE: UPL), which plays in the natural gas arena. As my Foolish colleague Dan Dzombak explains, Ultra is also in a great position now because of the management's focus on creating value. So that looks like an intriguing buy.